It is a well-established rule that lending money to family members or friends should not be done. Shakespeare admonishes us with his immortal words, “Neither a borrower nor a lender be.” However, it is the words that follow that inform us of the consequences, “For loan oft loses itself and friend.” This is just as true today as it was in the time of Hamlet — if you loan money to a friend or family member, you can expect to lose both the money and the relationship.

In a money-etiquette survey it was found that 57% of people have seen a relationship ruined because the borrower didn’t repay the loan. Still, many people who are in a position to do so feel compelled to help a close friend or family member in their time of need; and that doesn’t have to be a bad thing as long as you go about it with your eyes wide open. Here are some things to consider when your friends asking for money:

What’s More Important: Repayment or the Relationship?

If someone approaches you for a loan, chances are they aren’t creditworthy enough to qualify for a loan from a lender. So, you know going into it you are taking on the risk of not seeing all or some of the money again. The question becomes whether repayment of the loan or the relationship is more important to you. You should know in advance how you might handle a situation in which the borrower gets behind on payments or no longer returns your calls. You can expect things to get very awkward, especially if see the person at family events or around town.

Alternatively, if you truly value the relationship, you can treat the loan like a gift. With a better than 50% chance the loan won’t be fully repaid, earmarking it as a gift frees you of any stress. The person will likely try to repay you as if it was a loan, but the pressure is off the relationship.

Are You Helping or Enabling?

While you may have the right intent, you may be hurting the very person you are trying help. If the person needs money to cover basic living needs or to pay off credit card debt, loaning them money may only exacerbate their financial problems. What they might really need is financial counseling or help with finding alternative sources of income. If you do loan them money, do so under the condition they seek the help (or offer it yourself) they need to turn things around.

Don’t Make It Open-Ended

The problem with loaning money to a friend is they are often open-ended based on a handshake with no specific terms for repayment. That leaves both parties in a state of limbo with no expectations as to when the loan is to be repaid. It also creates a false notion in the mind of the borrower that there is no sense of urgency to repay the loan, especially when other things come up that relegate loan payments to low priority status. Without clear expectations or specific loan terms, it becomes difficult to approach the borrower about payments. If you are going to loan money, put it in writing with specific terms.

Is the Loan IRS Compliant?

Lending money to family or friends is often interest free, which is not a good idea. First, it diminishes the value you place on the money you loan someone; secondly, it could put you at odds with the IRS. Charging interest is not unreasonable, especially when it is done at below-market rates. The IRS expects you to charge interest on a family loan if you don’t want it to be treated as a gift for tax purposes.

The IRS doesn’t care about small loans made to children. Loans of $10,000 or less are not subject to gift tax rules if they are not used for investments. However, larger loans could show up on the IRS radar if appropriate interest is not charged. To avoid treatment as a taxable gift, the loan needs to be in writing with the amount, terms, and rate of interest clearly defined. The IRS requires a minimum interest rate to be charged which is reported as income by the lender. If the loan is made for a down payment on a house, the borrower may deduct interest charges, but the loan must be secured by a lien on the home.

What Are the Alternatives?

One alternative is to just say “no.” That may be hard to do, but, in many cases, it could be the right thing to do. Or, you can say “yes,” but with conditions. First, is that they at least try to obtain a personal loan on ﻿their ﻿own. While you don’t want them to get stuck with a “payday” type loan, there are alternative lending sources which can offer reasonably priced personal loans for people with less than good credit.

Author: Jeff Gitlen

Jeff Gitlen writes about a wide range of finance topics including everything from student loans to credit cards to small business financing. Jeff's work has been featured on a number of sites including Bloomberg, CNBC, Forbes, Market Watch, and more.

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